Copyright 2017 by Douglas T. Hicks, CPA, CMC,

A key element of the Half Cost Strategy is the ability to measure total cost to capture all the cost savings and encourage behavior to further reduce all costs.  Here is the easiest approach to quantify total cost.


In any change process, there is always some “low-hanging fruit” – those opportunities to show significant gains without expending a great deal of effort. Agents of change should always look for these opportunities as success in these high-leverage areas can generate interest and support for more ambitious efforts. They also provide a good way to get the change process started in cases where there is a lack of widespread support.

In implementing activity-based costing, low-hanging fruit can often be found by identifying and measuring the cost of the organization’s major cost drivers. Cost drivers are defined as the root causes of a cost – the things that “drive” costs. Associating costs with their drivers makes cost information more accurate and relevant and encourages behavior to lower or eliminate costs.

The cost of major cost drivers can usually be found “lumped together” with the costs from a wide variety of other, unrelated cost drivers in a single pool of costs known as overhead. This pool of overhead contains all costs that cannot be defined as either direct material or direct labor. They are blended together like peanut butter, incorrectly treated as a homogeneous pool of costs, and, like peanut butter, spread around to products and customers, usually using direct labor as a knife.

This overhead pool is almost always greater that the direct labor it follows and is often greater than the direct material portion of a company’s costs. It contains costs that relate to some of the company’s most important cost drivers. Without being linked to their causes, however, these costs are very difficult to understand and manage. For example, overhead pools usually contain the cost of activities related to:

 Engineering Change Orders
 Purchasing, receiving, testing, and storing raw materials and purchased components
 Quality, scrap, rework, and other non-value-adding activities
 Moving and storing in-process inventory
 Setting up or changing over equipment
 Handling and storage of finished goods
 Picking and shipping releases and orders

Yet few companies know the cost of an ECO, the “material overhead” related to the various types of direct items they purchase, the cost of an in-process move, the cost of setting up or changing over a piece of equipment, or the cost of post-manufacturing work (like storage and fulfillment) required to meet the demands of its various customers.

Fortunately, it is not necessary to precisely measure the costs or drivers to gain tremendous benefits from the exercise. Only a reasonable degree of accuracy is needed. As Oxenfeldt stated many years ago, “An error in measuring the magnitude of an effect usually is far less serious than mistakes due to wholly overlooked consequences.” 1

The key is to identify the major cost drivers and then develop the best estimates practical to measure the costs related to the driver and quantify the driver itself.

Although accountants might not be able to identify an organization’s cost drivers, they should be intuitively obvious to the company’s experienced managers once they understand the concept. Of the short list of seven drivers noted above, at least one should be a significant issue at any manager’s manufacturing firm. By selecting the one that appears most significant and estimating “the numbers,” insights should be gained that can significantly impact the company’s thinking.

For example, a $20 million forging company’s managers knew that their operating practices required a great deal of in-process movement and storage and that the cost of those activities added no value to the product. The costs of these activities were buried in the company’s direct labor-based overhead rates where they commingled with the cost of many other unrelated activities. The cost of in-process movement and storage was estimated at $1,250,000 and the number of moves at 360,000 – approximately $3.50 per move. By reorganizing the company’s workflow and scheduling practices, the company was able to reduce the number of moves by almost one-half, reduce the cost of movement and storage by $500,000 and liquidate approximately $500,000 of in-process inventory. Not bad for low-hanging fruit!

Once the connection is made between costs and their drivers, managers will be able to see the linkage between the characteristics and behavior of a product or customer and its total cost to the organization. This includes the impact of:

 Volume: high volume or low volume
 Degree of customization: standard or custom
 Part standardization: approved or preferred
 Part destination: production parts or spare parts for products that are out of production
 Distribution costs: direct or through channels
 Product age: launching or stabilized or aging (experiencing processing incompatibilities with newer products and/or availability challenges for parts and raw materials)
 Market niches: commercial, OEM, military, medical, or nuclear (different markets have varying demands for quality, paperwork, proposals, reports, certifications, traceability, etc.).

The insight provided by attaching costs to processes, products, and customers using the appropriate cost drivers clearly shows management where cost and investment reduction opportunities lie as shown in the following examples:

 Intel’s Systems Group. When Dr. Anderson implemented the parts standardization effort described in the standardization article, the result was that 500 “commonality” parts were identified as being preferred for new designs. These common parts really did deserve lower material overhead than the 13, 000 remaining “approved” parts because they were purchased in higher quantities. And the standardization program wanted to encourage engineers to use these parts. To accomplish both these goals, the Accounting Department structured material overhead into a two tiered system: one rate for the 13,000 approved parts and a lower rate for the 500 commonality parts. This reflected greater “material world” efficiencies and encouraged usage.

Tektronix Portable Instruments Division. To encourage part commonality and assign accurate material overhead, Tektronix assigned a material rate that was inversely proportional to volume. Thus, a high volume part had a very low overhead rate; conversely, a “low runner” was assigned a very high rate.2

Hewlet-Packard Roseville Network Division (RND). HP RND formerly had only two cost drivers for its printed circuit board assembly: direct labor hours and the number of insertions. A special survey showed that axial insertions were about one-third the cost of DIP insertions; manual insertion was three times as expensive as automation; and “low availability” parts had an additional cost of ten times their materials cost. So they implemented the following nine unit-based cost drivers.3

1. Axial insertions
2. Radial insertions
3. DIP insertions
4. Manual insertions
5. Test hours
6. Solder joints
7. Boards count
8. Part count
9. Number of slots

Hewlett-Packard Boise Surface Mount Center (BSMC) implemented the following ten cost drivers for surface mount printed circuit board manufacture.4  Note driver number seven which encourages part commonality.

    Cost Pools                                         Drivers

1. Panel Operations                            Percent of a whole panel

2. Small component placement            Number of “small” components placed

3. Medium component placement        Number of “medium” components placed

4. Large component placement           Number of “large”components placed

5. Thru-hole component insertion        Number of leaded components inserted

6. Hand load component placement     Minutes required to place components by hand

7. Material procurement & handling     Number of unique parts in the board

8. Scheduling                                     Number of scheduling hours

9. Assembly setup                               Number of minutes of setup time

10. Test & rework                              Number of “yielded” minutes of test & rework time

The following figure shows the changes in product costing after implementing these cost drivers. Note that one-third of the products had their costs go down and two-thirds had their costs go up, with one product doubling in cost!

Results: “Accountants now provide important inputs into product design and development decisions. Under the prior cost system, all overhead was applied as a percent of direct material cost, and it was difficult to understand how changing a board’s design would change manufacturing costs. Also, designers had little motivation to optimize the board for efficient production. With ABC, however, the cost system attempts to mirror the manufacturing process, so that engineers and production managers easily can see how design changes will affect cost.” 5

ADOPTING ABC – The Low-Hanging Fruit Approach

The incorporation of activity-based concepts into an organization’s decision making processes and finding its “low-hanging fruit” approach is presented in the book "Activity-Based Costing: Making it Work for Small and Mid-Sized Businesses" (Doug Hicks, 1999, Wiley).6  It is based on the premise that it is more important to identify those activities whose costs need to be measured and measure them accurately than to measure those costs precisely. In other words, a valid intellectual cost model of an organization is more important than a complex system to incorporate that model into the business’ day-to-day operations.

A valid cost model populated with reasonable estimates will provide a level of accuracy not that much different than a valid model populated with precisely measured actual data. It might even be more accurate, because precisely measured actual data contains day-to-day and month-to-month aberrations which can will distortions in the resulting cost calculations. Additionally, knowing that a product whose profit was calculated at 10.9% using a traditional cost model is actually losing 15%-20% is not that much less useful than knowing that it is losing precisely 17.25%.

The pursuit of precision in product costing is unrealistic and a waste of an organization’s resources. “No cost accounting system provides an organization with precision. All product costing is approximate. All cost systems contain too many estimates and allocations to be precise.”

With this focus on accuracy and relevance over precision it is easier to adopt activity-based costing (referred to as “abc” in lower case letters) than to implement a “full-blown” ABC system. By correctly identifying those activities an organization needs to measure, most of the battle is already won.

For example, by applying activity-based concepts to its operation, one company believed that the activity costs related to maintaining a spare parts inventory (which represented 20% of its purchases and 50% of its total parts inventory) would be much greater in relation to the parts involved than the activity costs supporting production parts, which are ordered using kanban and delivered directly to the line by vendors.. As a result, they establish an activity center to accumulate “Spare Parts Support” costs and another to accumulate “Production Parts Support” costs.

After analyzing the activities of support functions such as purchasing, receiving, quality control, accounts payable and engineering and determining the storage space occupied by each category of parts, the company is able to distribute an appropriate portion of the cost of each of these functions to the Spare Parts Support and Production Parts Support activity centers. Additionally, they knew from experience that only 70% of the spare parts acquired were ever used – the balance of 30% were scrapped after 5-7 years. This meant that for every $7 of spare parts used, $3 were thrown out – a situation that increases the cost of each spare part used by 43% even before any activity costs are added.

Needless to say, the company found out that their cost of maintaining a spare parts inventory far exceeded that required to maintain their production parts inventory – costs that had, under the old, traditional system, been spread evenly among all products as part of manufacturing overhead. Armed with this information, they were able to measure the cost reduction and cash flow enhancement benefits that would accrue from a design-for-manufacture program and initiate the changes that would make those benefits a reality.

They did it without measuring a cost per purchase order, a cost per receipt, or a cost per inspection. They did it without implementing an ABC system. They did it by deciding that knowing the cost required to support spare parts was important, incorporating it into their intellectual cost model, and performing the required calculations.

Developing intellectual cost models that incorporate only the essentials for understanding of an organization’s cost behavior make it possible to perform the required calculations using spreadsheet software and reap the harvest of the low-hanging fruit.

An alternative to creating a model on a spreadsheet would be software specifically developed for ABC analysis. The eight case studies, cited in the Institute of Management Accountants ABC study, all used such software packages on PCs.7


Most companies do not need a system as complex as would be needed for the multinational mega-corporation, despite misconceptions to the contrary. Implementing some degree of activity-based costing can be achieved with modest resources. Of the eight companies that implemented ABC in the Institute of Management Accounts study, the companies that used “medium involvement” of outside consultants took an average 6.5 months by 2.1 FTEs (full-time equivalent workers) to implement the ABC model. Companies that used “active involvement” of consultants took an average of three months by 1.6 FTEs.8

One practitioner reported that efforts to implement basic ABC have “ranged from 80 hours for a small commercial printer to 500 hours for a large automotive supplier with very poor historical financial and operating records.” 9


When ABC is implemented, companies start to see the real picture about product cost, which is often surprising. Cooper, Kaplan, et. al. refer to the “typical ABC pattern,” where several offerings are shown to be highly profitable, most at or near breakeven profitability, and a few highly unprofitable.10  A Schrader-Bellows case study11 showed that, out of seven products originally thought to be profitable, three actually were, one was barely breaking even, and three were unprofitable, with one highly unprofitable.

Total cost analyses often adjust manufacturing costs up for most products, while lowering them only for a few “deserving” products. After HP implementing the nine cost drivers cited above, they found that 72% of the products were really costing more than assumed, as shown in Figure7-2. Cost adjustments ranged from slightly lower to double!12

    DOUGLAS T. HICKS, CPA, CMC.  In his twenty years of consulting, Doug Hicks has helped nearly 200 organizations transform their traditional cost accounting data into customized, value-enhancing decision support information that provides their decision makers with the accurate and relevant cost information they need to thrive and grow in a competitive world. His articles have been published in dozens of trade and professional periodicals, including Manufacturing Engineering, Modern Casting, Management Accounting, and Plastic Technology and his two books on activity-based costing6 have sold over 15,000 copies worldwide. Doug is a 1970 graduate of the University of Michigan – Dearborn. In 1997 he was awarded the University’s 1997 “Professional Growth and Scholarship Award” for his role as a leader in advancing cost management concepts. He is a member of the Institute of Management Accountants, the Institute of Management Consultants, and the Michigan Association of CPAs.


For more information, phone or e-mail

Douglas T. Hicks, CPA, CMC
25882 Orchard Lake Road, Suite 207
Farmington Hills, MI 48336
Tel: 248.471.9060
Fax: 248.471.6572


1. Oxenfeldt, Alfred, R. Cost-Benefit Analysis for Executive Decision Making: The Danger of Plain Common Sense, (New York, AMACOM Books, 1979), p. 223

2. Robin Cooper and Peter B. B. Turney, “Internally Focused Activity-Based Costing Systems,” Measures of Manufacturing Excellence, edited by Robert S. Kaplan (1990, Harvard Business School Press), pp. 292 - 293.

3.  Ibid., pp. 294-296.

4. Mike Merz, Professor of Accounting at Boise State University, and Arlene Harding, Finance Supervisor at HP BSMC, “ABC Puts Accountants on Design Team at HP,” Management Accounting, (September 1993), pp. 22 - 27.

5. Ibid., pp. 22 - 27.

6. Doug Hicks, "Activity-Based Costing: Making it Work for Small and Mid-Sized Businesses" (1999, Wiley).  Link to book description on

7. Cooper, Kaplan, Morrissey, and Oehm, Implementing Activity-Based Cost Management, pp. 6, 25, and 256.

8. Ibid., p. 296.

9. Hicks, "Activity-Based Costing for Small and Mid-Sized Business," (1992, Wiley) p. 9.

10. Cooper, Kaplan, Morrissey, and Oehm, Implementing Activity-Based Cost Management, p. 5.

11. The Schrader-Bellows case study is described in Harvard Business School Case Series 9-186-272; A summary of the findings appears in “How Cost Accounting Distorts Product Costs,” by Robin Cooper and Robert S. Kaplan, Management Accounting, (April, 1988).

12. Merz and Hardy, “ABC Puts Accountants on Design Team at HP,” Management Accounting, September 1993, pp. 22 - 27.